Financial market sentiment can remain resolute for an extended period before shifting abruptly when the underlying economic narrative changes.

India’s monetary policy expectations have followed a similar pattern. After the Monetary Policy Committee’s last rate cut in December 2025, the median forecast in the RBI’s Survey of Professional Forecasters pointed to an extended pause through 2026–27. This changed ahead of the June 2026 policy review, with market expectations shifting towards 50 basis points of rate hikes in the second half of 2026–27, given the persistence and severity of the West Asia crisis and its spillover impact on the rupee.

However, with the RBI taking unconventional steps to bolster capital flows through targeted regulatory measures, immediate concerns about the rupee abated, leading market participants in August to prune expectations to just one rate hike in January–March 2026–27.

Two months later, the chorus for rate hikes is back.

The earlier expectation of 50 bps of cumulative rate hikes is now accompanied by a ‘fat tail’, with a few market players also considering cumulative increases of 75 bps by January–March 2026–27. The urgency has also increased, with a consensus now emerging that the MPC will opt for a 25 bps rate hike at its policy review scheduled for October 7.

So, why did market expectations change so dramatically in two months despite these bumper special forex inflows?

Changing Balance
The most obvious shift in the economic narrative lies in the growth-inflation balance. India’s GDP growth of 7.8% year on year in April–June 2026–27, along with the signals from high-frequency indicators for July–September 2026–27, underscores the economy’s resilience. Although the ongoing West Aisa crisis has created pockets of disruption, policy buffers have helped mitigate the overall spillover impact.

In contrast, the price shock continues to pass through the economy, and the renewed spike in energy prices since August, along with shipping costs at multi-year highs, could hasten the process.

After averaging $84 per barrel in July 2026, spot Brent crude oil rose to $91 in August and $114 in September. With the festive season having begun, anecdotal evidence suggests producers are using this as an opportunity to pass on higher costs. This is expected to lift core CPI inflation (excluding food and beverages, along with all fuel items) from 3.7% in January–March 2025–26, when the West Asia crisis began, towards 4.8% in January–March 2026–27.

In addition, headline CPI inflation is also facing upside pressure from food prices, which could intensify in the coming months as the full impact of one of the worst monsoon in over a decade is realised. At the time of writing, the Union Ministry of Agriculture had confirmed five drought-affected states: Maharashtra, Karnataka, Andhra Pradesh, Telangana and Rajasthan. Maharashtra and Andhra Pradesh had officially notified drought conditions across 34 and 21 districts, respectively, while Uttar Pradesh was surveying 17 districts that faced severe rainfall deficiency.

CPI inflation may accelerate sharply from a relatively benign average of 4.2% during April–August 2026–27 to an average of 6.0% during September–March 2026–27. Because monetary policy changes have a lagged impact, this offers a clear case for changing course in time to avoid a knee-jerk reaction later.

This is perhaps what two of the internal members of the MPC have started preparing market participants for. In the August 2026 MPC minutes, Deputy Governor Gupta said a case for a hike could emerge during the year, with headline inflation projected to peak at 5.9% in October–December 2026–27. Governor Malhotra pointed to signs of inflation normalising from its previously benign levels, which he said could suggest a recalibration of the policy rate.

A cursory glance at the start of the previous two rate-hike cycles since the adoption of the flexible inflation targeting regime suggests something similar.

• The June 2018 episode marked the first rate hike after a 10-month pause. The real repo rate on an ex ante basis (the nominal repo rate deflated by the RBI’s projected CPI inflation) was already around 1%. Nevertheless, the MPC chose to raise the repo rate in good time, and the cycle that followed was shallow, lasting just three months.
• In contrast, the May 2022 episode, which marked the first rate hike after a 23-month pause, was characterised by high projected inflation and a negative real policy rate. This was followed by the fastest pace of monetary tightening India has ever witnessed.

 Note: Figures in parentheses indicate the repo rate level during the pause phase, just before the start of the rate-hike cycle.
Data source: RBI

Monetary Equilibrium
Beyond the growth-inflation dynamic, rate hikes must address other parameters that, although they may not appear urgent, matter structurally over the medium term.

• In a world economy warped by geoeconomic and geopolitical uncertainties, India has been facing balance-of-payments (BoP) headwinds. The BoP registered deficits in both 2024–25 and 2025–26. The 2026–27 outcome was set to follow a similar pattern, but the RBI’s regulatory intervention prevented it. However, the threat looms. The 2026–27 BoP surplus will be highly concentrated, likely within just three months, leaving the BoP exposed to global volatility, thereby maintaining some depreciation pressure on the rupee. Although rate hikes might not be the first port of call to support the BoP, persistent, elevated commodity prices (widening the current account deficit) and near-coordinated monetary policy tightening in key regions across developed and emerging markets (which could alter global capital flows) could still make them necessary. Notably, after the US Fed raised its policy rate by 25 bps in September 2026, market participants are pricing in about three to four additional rate hikes before the end of 2027.
• Low real interest rates disincentivise deposit mobilisation (the current spurt reflects higher interest rates offered to non-resident Indian (NRI) depositors rather than residents) while pushing currency in circulation higher. Notably, the incremental currency-deposit ratio has trended up from a low of 5.9% in April–June 2024–25 to 15.6% in April–June 2026–27, despite impressive progress in the use of digital payments, especially UPI. Restoring the real policy rate to its broad long-term average range of 1–2% on a forward-looking basis could help improve the currency-deposit balance, a key determinant of structural banking liquidity.

Policy Outlook
Speaking of banking liquidity, a rate hike will be effective only if overnight money market rates are aligned with the repo rate. Currently, special forex inflows have injected about ₹13.7 trillion of durable liquidity into the banking system, of which the central bank has sterilised about 28% through durable instruments (open market sales and foreign exchange sales, including spot and forward transactions along with sell-buy swaps), and absorbed about 17% through temporary tools (variable rate reverse repo auctions). About 3% has been drained by organic factors (reserve maintenance and demand for cash).

Although organic factors will become a prominent channel for draining excess liquidity (about 33% of the one-time liquidity injected by special forex inflows) over the second half of 2026–27, the RBI could hasten the normalisation of its liquidity adjustment facility (LAF) operations by stepping up further foreign exchange sales or using cash management bills in consultation with the government.

Once monetary policy changes course, market participants will focus on the terminal rate, which can vary from cycle to cycle. We believe the current phase lies between the June 2018 and May 2022 episodes. If monetary policy normalisation is not delayed, the cycle could be short-lived. We expect the MPC to pause for assessment after delivering three 25 bps rate hikes between October 2026 and February 2027.